U.S. stock prices point to possibility of extended correction

KateGibson

NEW YORK (MarketWatch) -- Equity valuations point to further consolidation or even an extended correction for the U.S. stock market, among other indicators, some analysts say.

The usual matrixes for determining the value of what investors are paying for stocks should be put in context, given "this isn't a normal environment for valuations," said Ed Clissold, senior global analyst at Ned Davis Research.

But Clissold believes stock valuations are at or near their ceiling, at least if one puts them in context of the last half a dozen or so years.

Yale economist Robert Shiller looks at 10-year average earnings adjusted for inflation, which Clissold views as a reasonable approach. His firm uses a similar concept, which involves looking at the median price-to-earnings ratio of the S&P 500 Index
SPX, +0.59%

The price-to-earnings ratio for equities is about 22, putting it about one standard deviation above its long-term average, based on numbers running back to 1968, Clissold said. "Over the past seven years, the median P/E has struggled to get above the 22 to 24 range, so there is that valuation ceiling out there and we're getting close to it," he added.

Sectors can have blowout profits, such as the ones energy firms enjoyed when oil topped $100 a barrel in summer 2008. Conversely, companies can face severe problems, like financial firms did last year. "Therefore we take all the P/Es for the 500 S&P stocks and pick the middle," elaborated Clissold.

Investors look at P/E ratios, or a comparison of stock prices to the company's earnings strength, to determine whether buyers have bid up prices too high compared with the underlying value of the company.

But there are many ways to look at valuation, starting with whether one compares prices to past earnings -- or to expected future earnings.

Earnings hopes

Owen Fitzpatrick, head of the U.S. equity group at Deutsche Bank, said he views valuation at "very reasonable" at 14 times the $77 to $78 a share estimate. That's based on average expected earnings for S&P 500 companies.

Valuations are pricing in a sharp rebound in earnings, according to Bill Stone, chief investment strategist at PNC Wealth Management.

Consensus future-earnings estimates for the S&P 500 currently stand at about $77 a share, a figure that has stocks "reasonably priced" if one accepts the premise that there will be a V-shaped earnings recovery, said Stone, who concurs with the V-shaped concept.

It's typical for the market to rally on anticipated earnings growth toward the end of a recession, but as earnings start to stabilize, sales growth is needed for the market to continue higher.

"If a sales recovery finally begins to be apparent, this should help provide the earnings leverage to support a sharp earnings recovery and bolster our view that the S&P 500 can produce $75 per share in earnings in 2010," he commented.

On Monday, stocks rebounded after posting the worst month since February 2009.

The S&P 500 rose 1.4% to 1,089 after sinking 3.7% in January. The Dow Jones Industrial Average
DJIA, +0.72%
ended 118 points higher, up 1.2% at 10,185.5. The gains represented the Dow's biggest rise in point and percentage terms since a 156-point gain on Jan. 4.

Warning signs

Yet Stone and others acknowledge there are signs the market could falter again.

If viewed through the rearview mirror of recent past earnings, then the argument for stocks is much less compelling, Stone said. "If indeed forward-earnings estimates prove correct, then it seems likely that stocks should be priced higher. If instead it takes longer to reach that earnings level, then probabilities are higher that stocks will come under pressure while earnings catch up."

The strategist also believes the market's near-uninterrupted 70% rise from March 2009 lows leaves it vulnerable to a correction -- especially given that in the last 10 months, there hasn't been one of as much as 10%.

"Usually when you go for this extended period of time, we would have had a correction," said Fitzpatrick, who calls it healthy for the market.

Just how extended that correction might be comes down to factors including China, as well as what corporations have to say about earnings and sales growth ahead.

"With the consumer strapped with debt and unable to borrow like in the past, consumption will be less than at the beginning of other economic expansions," said Clissold at Ned Davis.

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